Class XII Accounts Fundamental Concepts
Accounts - Reconstitution by Changing Ratios
partnership business may undergo several structural changes during its lifetime.
When the existing partners of a firm decide to reconstitute their business by
changing their profit sharing ratio, it becomes essential to make appropriate
accounting steps. Reconstitution of partnership can take place as a result of
decision by the partners to change their profit sharing ratio, or by way of
admission of a new partner, retirement of a partner or by death of a partner.
The following are the essential aspects to be considered on reconstitution of
the partnership among existing partners.
Change in profit sharing ratio among existing partners; sacrificing ratio and
Distribution of reserves and accumulated profits
Revaluation of assets and liabilities
Treatment of goodwill
Readjustment of capital accounts
Change in Profit Sharing Ratio among existing partners - Sacrificing Ratio and
partners may decide to change their profit sharing ratio for various reasons.
When the profit sharing ratio is revised among existing partners, there ought to
be a partial sacrifice of profit share by some partners in favour of others. The
sacrifice of one or a group of partners becomes the gain of the remaining
partners. When the profit sharing ratio is revised it is important to calculate
the sacrificing ratio and gaining ratio. These ratios are required to adjust the
value of goodwill of a firm without raising goodwill account in the books.
Sacrifice / gain ratios can be applied to adjust the profit or loss on
revaluation of assets and liabilities in the capital accounts of partners
without actually changing the values of those assets and liabilities.
the most important rule in adjusting sacrifice/gain in all situations:
Gaining Partner Dr.
To Sacrificing Partner
of calculating sacrificing ratio and gaining ratio
ratio in partnership accounting is the ratio in which existing partners
sacrifice their share of profit. This happens due to a revision in profit
sharing ratio or admission of a new partner. This is calculated by deducting the
new ratio from the old. When there is sacrifice new ratio is always lower than
ratio is the opposite of sacrificing ratio. This is the ratio gain to the
existing partners of a firm when they revise the profit sharing ratio, or when
the profit share of the deceased or retired partner is shared by the other
partners. This ratio is calculated by deducting the old ratio from the new
ratio. The new share will be higher than the old when there is a gain.
to calculate sacrificing ratio and gaining ratio
there is a revision of profit sharing ratio by existing partners, there will be
sacrifice as well as gain within the same partnership. Therefore it is easier to
stick to one formula. Take the result of new ratio minus old ratio. If the
result is negative it is sacrifice; and positive it is gain.
the steps once again:
the new ratio in the first line
the old ratio in the second line (remember to adjust the ratios to add up to
the a convenient total)
the old from new
result indicates sacrifice; positive result indicates gain
Revaluation of Assets and Liabilities
and liabilities are often shown in the accounts at their historical value rather
than realisable value. Due to conservatism the partners usually do not revise
the values of assets even when their actual market values are much higher than
book values. Similarly inadequate depreciation, change in technology etc. make
the book values of certain assets more than their realisable value. It is not
practical for the partners to keep on changing the book values of their assets
according to their market values. The difference between book value and market
value is not a problem as long as the partnership business goes on normally. But
when they change the structure of the partnership in the form of revision in
profit sharing ratio, admission of a new partner, retirement or death of a
partner, amalgamation of two partnership firms, absorption of a firm by another
etc., the values of assets and liabilities are to be reassessed and difference
if any, should be accounted.
is the purpose of revaluation?
the realisable value of asset or liability is different from the book value
there is a profit or loss is hidden in the difference in value. The partners are
entitled to all the profits and loss in the existing profit sharing ratio. If
the ratio remains unchanged there is practically no use in estimating the hidden
profit or loss. However, if the partners want to change the profit sharing
ratio, this hidden profit or loss should be distributed first before changing
the ratio. If this profit or loss is not distributed prior to changing profit
sharing ratio some partners are likely to lose and others gain due to the change
example: A&B, who were equal partners purchased land for Rs.10,000 in Jan
1975. They decided to share profits and losses in the ratio 2:1 from 1st
January 2001. The market value of land on 1st January stood at
Rs.70,000; whereas the book value remains at the purchase price of Rs.10,000.
There is a hidden profit of Rs.60,000 in the value of land which A & B
entitled to share Rs.30,000 each. Suppose they ignored this factor and changed
the profit sharing ratio to 2:1 and sold the land for Rs.70,000 afterwards, the
profit on sale of land Rs.60,000 will go to A and B in the new ratio 2:1, which
means A will get 40,000 and B will get only 20,000. In other words Rs.10,000
belonging to B will wrongfully go to A. Vice versa can happen in case of a
hidden loss. To prevent such problems the partners revalue the assets and
liabilities and transfer the net result into their capital accounts in the
existing ratio before making a change.
the value of one asset is to be increased in the books it can be easily done by
debiting the asset and crediting it to partners’ capital accounts in the
profit sharing ratio. But when there is a major shake up, values of almost every
asset and liabilities are to be revised. For the purpose of convenience, revised
values of assets and liabilities are brought into books by opening a temporary
account called ‘revaluation account’. The revaluation account summarises the
effect of revaluation of assets and liabilities.
account is a special profit & loss account representing the combined capital
accounts of partners. Any gain on revaluation of asset or liabilities, which are
to be credited to partners, will be credited in the revaluation account.
Similarly any loss on revaluation will be debited in revaluation account instead
of debiting the capital accounts. The final balance in revaluation account
indicates the profit or loss on the entire revaluation process. The revaluation
account is closed by transferring this profit or loss to partner’s capital
accounts in the ratio before revision (old profit sharing ratio). All assets and
liabilities will appear at their revised values in the books and in all future
the partners want to adjust the profit or loss on revaluation process without
actually changing the values of assets and liabilities in the books they can do
so by opening a memorandum revaluation account. This revaluation account
has two parts. The first part is a normal revaluation account and the profit or
loss on this part is transferred in the old profit sharing ratio. The second
part of memorandum revaluation account is almost a mirror image of the first
part. Whatever debited in the first section is credited in the second and
whatever credited is debited. Naturally if there was profit in the first
section, there will be loss in the second and vice versa. The profit or loss in
the first part is transferred to capital accounts in the old ratio, and that at
the second part will be transferred to capital accounts new profit sharing
ratio. As a result of this exercise the effect of profit or loss on revaluation
will be fairly embedded in the capital accounts of partners.
Distribution of Reserves and Accumulated Profits
of reserves and accumulated profits is the first step in any reorganisation
process. They include general reserves, credit balance in P & L accounts or
any other fund that are retained in the business. These are profits earned in
the past, but not taken out by the partners, or profits kept aside. Therefore,
when the partners decide to change their future profit sharing ratio, the past
profits retained in the above accounts should be distributed to partners in the
old ratio as a first step.
is an intangible asset
is a valuable asset.
generates extra income for the business
is acquired in a gradual process
are the major situations in which the goodwill of the firm is to be estimated.
Change in profit sharing ratio
Admission of a new partner
Retirement or death of a partner
Amalgamation of two partnership firms
Absorption of a firm by another one
are several factors that influence the formation of goodwill. The following are
some of the important factors helping the formation of goodwill in a business.
firm builds up its reputation over a long period by consistent good dealing with
the customers. Once the customers start identifying a business for clean and
honest dealings they would prefer to stay with the firm, which in turn help the
firm to earn higher profits.
quality of products
manufacturing concern maintaining a very good quality in their production will
gradually build up reputation, which will help them while launching new
products. Similarly trading concerns dealing only in good quality products will
gradually build up their reputation.
location of the business is another favourable factor enhancing the
profitability and thereby goodwill of the business. A business which is
centrally located will naturally attract more business and more profit.
skill or Technical Know-how
business builds up skill in dealing with their product line, dealing with the
clients’ specific requirements, problems associated with the geographical
location of their business etc. through experience. The problems are wide and
varied, and solutions are also equally diverse. Thus the actual experience help
develop skill in dealing with similar situations in future, which is naturally
promote efficiency and goodwill of the business.
established business concerns manage to build up their monopoly simply by being
the first one in the market. This enables them to establish its position in and
to some extent, restrict future competition. Even though, monopolies are
undesirable from the customer’s point of view, they are unavoidable and
harmless at a limited scale.
of Valuation of Goodwill
are the most common methods adopted for valuation of Goodwill.
profit method, as the name suggests, is based on the average profit of the
business. Under this method, average profits for the past three or four
years as agreed by the partners will be taken. Goodwill is estimated as twice or
thrice of this average profit.
existence of Goodwill is recognised in a firm only when its profitability is
beyond the level of a new firm. Such excess profit earned by the firm is termed
as super profit.
Method (Goodwill based on Capital Saved)
method considers goodwill as the value of capital saved due to higher
profitability. Under this method the amount of effective capital is estimated on
the basis of market condition. This effective capital is always higher than the
actual capital due to better profitability. The excess of effective capital over
the actual capital is regarded as capital saved which is considered the goodwill
of the firm. Capitalization of super profit and capitalization of actual profit
and estimation of capital saved as goodwill are practically the same.
Treatment of Goodwill
the value of goodwill is estimated it should be properly accounted prior to
readjustment of profit sharing ratio. There are basically three methods of
treatment of goodwill which are:
Method (discarded by CBSE)
Revaluation Method (discarded by CBSE)
method is used when the partners do not want the goodwill account to appear in
the books and to adjust the goodwill only through the capital accounts. When
profit sharing ratio is changed what actually happens is something is added or
deducted from their old profit share. In other words they retain a major part of
their old profit share for which no adjustment is required. Goodwill under this
method is adjusted on the basis of marginal increase or decrease of goodwill.
The basic rule is that the gaining partner shall compensate the sacrificing
are the steps involved in goodwill adjustment.
out the partner’s sacrifice / gain
gaining partner and credit the sacrificing partner with the proportionate value
you find the ratios bit difficult, you can arrive at the margin values by
following memorandum revaluation in a different format in the workings. This is
basically crediting full value of goodwill to partners’ capital accounts in
the old ratio and debiting it in the new ratio. The net result is premium being
adjusted in the account. You are not allowed to show these entries in the
capital account. But the examiner has no problem if you do it in the workings.
I followed this method in all illustrations in "Concise Accountancy"
Adjustment of Capital Accounts
the partners change their profit sharing ratio, they may also change their
capitals. Contribution of capital is not essentially the basis of profit
sharing. But in most cases capital contribution is considered the most important
factor in determining profit sharing ratio. Capital balances are usually
adjusted by bringing in or taking out cash. However as a temporary measure
capital balances can be adjusted by transferring the differences through current
any four factors which influence the valuation of goodwill
what occasions does the need for valuation of goodwill arise?
are the different methods of valuation of goodwill?
between ‘average profit’ and ‘super profit’ methods of goodwill.
the revaluation method of treatment of goodwill.
is sacrificing ratio?
two circumstances in which sacrificing ratio must be applied.
is there a need for revaluation of assets and liabilities of a firm, if there is
a change in profit sharing ratio?
between Revaluation Account and Memorandum Revaluation Account.
various accounting steps involved in the in the reconstitution among existing